1) Rain Makers Corporation is negotiating a five-year contract with its new CEO,
ID: 2471177 • Letter: 1
Question
1) Rain Makers Corporation is negotiating a five-year contract with its new CEO, Earl Honeywood. The corporation
has proposed two contract options for the CEO, outlined as follows:
OPTION 1: A five-year contract, starting January 1, Year 1, for $7,000,000. Earl Honeywood would be
paid $1,400,000 each year at the end of the year (December 31) for five consecutive years.
OPTION 2: A five-year contract, starting January 1, Year 1, for $7,800,000. Earl Honeywood would be
paid at the end of each year (December 31). He would receive $1,100,000 in Years 1 through
3, and then $2,250,000 in Years 4 and 5.
You have been hired as Earl’s investment manager, and believe that Earl should consider the time value of money at
12% before making his decision. Calculate the present value of the two contract options to aid Earl in his decision.
A) Present Value of OPTION 1:
B) Present Value of OPTION 2:
Explanation / Answer
Solution :
Option 1
Present value of 14,00,000 paid at the end of each year for 5 years
1400000*3.60478
5,046,686.68
Option 2
Presentt value
Year 1-3
1100000*2.40183
2,642,014.40
year 4-5
2250000*1.20294
2,706,626.10
Total
5,348,640.50
1/(1+r)^n
Year
Discount factor at 12%
1
0.892857143
2
0.797193878
3
0.711780248
2.401831268
Year 1-3
4
0.635518078
5
0.567426856
1.202944934
Year 4-5
3.604776202
Option 2 is better as it has higher present value.
Option 1
Present value of 14,00,000 paid at the end of each year for 5 years
1400000*3.60478
5,046,686.68
Option 2
Presentt value
Year 1-3
1100000*2.40183
2,642,014.40
year 4-5
2250000*1.20294
2,706,626.10
Total
5,348,640.50
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